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Rising interest rates?

The Bank of Canada speculated about raising interest rates . This is not very surprising, since interest rates in the US have been higher than Canada for years. I was curious if that meant their CDs (their version of our GICs) paid a higher interest rate, but they don’t. Here are a couple things that might happen with rising interest rates.

Higher cost of borrowing — As interest rates rise, costs of borrowing rise. It will be more expensive to get a mortgage, to get a personal loan or to get a business loan. Many loans are based on a spread above prime, such as a variable mortgage at “prime + 0.5%”. When prime moves from 2.7% to something higher, the variable mortgage (or other variable loan) rate increases immediately. This could increase loan payment requirements or extend loan repayment timelines for consumers and businesses.

Lower bond prices — When interest rates rise, bond values fall. If the Bank of Canada raises rates, investors will likely require a higher yield on bonds that they buy. In order to get a higher yield on bonds, which pay a steady coupon, investors will offer a lower price. This will likely affect existing investments in bonds as well as ETFs and mutual funds that hold bonds. Preferred shares are also affected the same way — their yield will increase through a falling market price.

Higher mortgage cost and lower house prices — Rising interest rates may not affect the majority of existing mortgages, which are often at a fixed rate, but mortgages for a new house purchase (as well as renewals) will be at a higher rate. Because of higher interest costs, buyers will be faced with larger monthly payments for the same size mortgage. More likely, they’ll be able to afford a smaller mortgage for the same monthly payment. This might be good news for Vancouver and Toronto.

Higher financial company profits — When interest rates are really low, banks and other financial companies can’t charge a very large spread between deposits (such as GICs) and loans (such as mortgages). As interest rates rise, lending rates will (likely) rise faster than deposit rates, and spreads could increase, producing greater profitability for financial companies.

Stronger Canadian dollar — A higher interest rate should increase the demand of foreigners to buy Canadian dollars, to purchase Canadian-denominated bonds. It could also decrease the likelihood of Canadians converting their cash into other currencies to earn a better interest rate.

Reduced economic activity — Increasing interest rates will also cause business costs to rise for companies that borrow to fund their operations, which is most of them. More highly-leveraged companies (seen in the debt-to-equity ratio or the Dupont model financial leverage) will experience greater effects. Think of the example of a landlord where the tenant’s rent covers the mortgage payment. Now, with mortgage rates increasing, landlords have to decide to either raise the rent or to stop renting. Construction projects could be impacted in a similar way.

2 thoughts on “Rising interest rates?”

Wasn’t expecting to see your analysis so quickly. One question though – why would preferred shares fall? I’ve owned ZBR for a couple of years now and saw its price fall when Canadian interest rates went from 1.25 to .75 in 2015.

I’ve hung onto it since and seen some some capital appreciation in 2016 but was anticipating that eventually rising rates would reprice it even higher. Is that foolish thinking? Am content to keep collecting the juicy monthly yield but am I wrong to think there is likely capital appreciation coming with rising rates? Why?

I’m not an expert on preferred shares, but this is how I understand they work. Generally, they are issued at par, at a price of $25.00. They may trade above or below $25.00, but the purpose of most investors is to buy them for the dividend. The dividend is paid as a fixed base rate that doesn’t change over the lifetime of the preferred share. Let’s use a hypothetical example of $1.00 of dividend for a $25.00 preferred share.

$1.00 ÷ $25.00 = 4% yield.

Let’s suppose that investors are happy with a 5% yield, so they buy the shares. As interest rates go up and down, these shares will continue to pay a $1.00 dividend or a 4% yield. Which is fine for the people who own the shares.

But if they want to sell their shares, they must agree on a price with investors who want to buy the shares. This is the market price (of course). If interest rates fall to 3.5%, then investors will be willing to pay more for a share paying $1.00 of income. In fact, they would be willing to pay $28.57, which means that the market price has risen in response to falling interest rates. The opposite is also true. If investors are demanding a 6% yield, then the price they are willing to pay for $1.00 of dividend income will fall to $16.67.

These generalizations may not always hold true. Companies could skip a dividend payment (which will be caught up before common shares get a dividend payment) or they could increase or decrease dividends. Further, the taxation of dividends is different from interest, and could affect the willingness of investors to accept a lower yield.

To answer your question, barring changes in interest rates, I would only expect the price of preferred shares to rise if the dividend declared by the company were to rise. I don’t think that’s usual with preferred shares, but I don’t really know.

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